SEC's New Crowdfunding Rules Explained

Instead of sending out early products in exchange for funding, startups are one step closer to being able to sell company shares to willing investors through crowdfunding sites. This week, the SEC voted unanimously to propose rules that would allow companies to sell shares (equity) through crowdfunding sites – a process known as equity crowdfunding. While this was formally legalized in 2012 when President Obama signed the JOBS Act into law, equity crowdfunding can’t occur until the SEC finalizes rules overseeing this type of offering. Made popular in recent years through sites like Kickstarter and IndieGoGo, crowdfunding has traditionally allowed companies to raise money from friends, family and strangers in exchange for special goods, like an autographed DVD or a limited-edition gadget. In an SEC press release, the commission notes that SEC Chair Mary Jo White recognizes the intent of the JOBS Act is twofold: to help startups and small businesses raise capital while increasing the number of opportunities for investors. “There is a great deal of excitement in the marketplace about the crowdfunding exemption, and I’m pleased that we’re in a position to seek public comment on a proposal to permit crowdfunding,” said SEC Chair White.  “We want this market to thrive in a safe manner for investors.” There is now a 90-day public commenting period open for the guidelines, after which, the SEC will issue the the finalized version of the rules.Proposed Rules: Going Too Far, or Just Right? Earlier this week, Senators John Thune (R-SD) and Pat Toomey (R-PA) wrote a letter to White expressing concerns that proposed SEC rules surrounding other aspects of the JOBS Act were going too far and limiting the law’s intent to make it easier for small businesses to raise money. But when it comes to equity crowdfunding, McDermott, Will & Emery partner Thomas Murphy, who heads up the firm’s securities and capital markets group, says the SEC more or less stuck to the letter of the law. “They hewed pretty closely to what the statute required – they didn’t go out on a limb too much in exercising authority to cut back or expand requirements,” says Murphy, who says the JOBS Act was already fairly specific when it came to equity crowdfunding. Under the proposed rules, the SEC says a company would be limited to raising $1 million through crowdfunding in a one-year period. Over the same time period, investors would only be able to invest $2,000 or 5% of their annual income or net worth, whichever one is greater, if their income or net worth is less than $100,000. For investors making more than $100,000, or who have net worth greater than that amount, the limit is 10%, or up to $100,000 maximum. Surprisingly, says Murphy, the SEC says potential investors would not be required to verify their income or net worth – they could simply check a box, for instance. Already, this is attracting a lot of attention, and the SEC will likely receive comments that this should be tightened up in order to protect investors.Will Equity Crowdfunding Be Too Expensive for Startups? Popular crowdfunding sites like Kickstarter make it really easy for individuals to give money; simply create an account and donate. Since equity crowdfunding is regulated by the SEC, however, there are greater requirements, both for the company seeking funding and the funding “portals” facilitating crowdfunding. In the proposed rules, the SEC says companies need to provide documents with information about officers, directors and owners who hold 20% or more of the company; a description of the business and how the crowdfunding proceeds will be used; the price of the securities being offered; and financial statements, including tax returns reviewed by an accountant or auditor. The portals, on the other hand, need to provide investors with proper educational materials and take measures to reduce the risk of fraud in order to be approved by the SEC. Once again, Murphy says these proposed rules closely reflect the way the JOBS Act was written. Given that there were already a lot of requirements surrounding equity crowdfunding in the law, Murphy says it’s surprising that so many entrepreneurs believe that equity crowdfunding will be an easy route to raising money. “I think it will be one of the most expensive ways to raise money,” says Murphy, who estimates that legal fees and time spent will eat up as much as 25% of any money raised through crowdfunding portals. “I’m skeptical that crowdfunding is going to be an efficient and viable funding mechanism for very many people,” adds Murphy, who says there’s been more hype and hoopla around equity crowdfunding than it necessarily deserves. Bernhard Schroeder, director of San Diego State University’s Lavin Entrepreneurship Center, however, believes that equity crowdfunding will be a viable path for many entrepreneurs looking to raise a little bit of money without giving up a lot of equity. “The typical VC deal gets between 24% and 28% of equity in the first A round,” says Schroeder. “I think companies will raise $1 million and not give up more than 5% to 10% issuing micro shares.” That said, Schroeder is doubtful that serious investors will be flocking to crowdfunding sites looking to drop a lot of money on the next big thing. “I don’t think anyone will get rich [on equity crowdfunding] except perhaps the entrepreneurs,” says Schroeder.What the Proposed Rules Mean for Crowdfunding Portals Attorney and entrepreneur Kendall Almerico, who already runs two crowdfunding sites, also believes that the proposed rules may turn off some entrepreneurs who would have otherwise been interested in equity crowdfunding. “They thought it was going to be easy and cheap, and it’s not going to be either,” says Almerico. Despite this, Almerico says he still intends to open an equity crowdfunding portal. “We’re definitely going to go into equity crowdfunding, and we’re set up to do so,” says Almerico. However, he thinks some of the SEC’s proposed rules may scare off some potential competitors. “The cost of entry is going to be several hundred thousand dollars,” says Almerico, due to the SEC’s proposed compliance requirements.